The Kyoto Protocol defines one carbon credit as the permission or the allowance for emission of one ton of carbon dioxide or carbon dioxide equivalent gases. They are an integral part of any discussion pertaining to global warming, yet one whose nuances are not widely understood or known. Not only is the credit system an environmental threat, it also has financial repercussions.

The carbon credit and emission trading system is a trade-able permit system. It is also commonly referred to as the cap-and-trade system. Its working is somewhat similar to the US Acid Rain Program to reduce industrial pollutants. In this system, as established in the Kyoto Protocol and further explained in the Marrakesh Accords, each country decides upon a ‘cap’, which is the maximum amount of emissions allowed to a certain developed or developing nation. Moreover, this cap decreases with time thereby bringing about a net reduction in global emissions. It is the responsibility of the government to ensure that this cap is followed. The government in turn, puts caps on companies or industries operating in its nation. This whole capping system is managed by the internal registries in a country that have been set up for this purpose and are in turn monitored by the UNFCCC (United Nations Framework Convention on Climate Change).

The trade portion of this system comes in the form of carbon credits. Each country is allotted some carbon ‘credits’ or quotas, which reflect their required emission levels and the cap that has been decided for them. Once again, the government allots these credits to its local businesses, giving them an idea of how much they are allowed to emit. The trading system is easily explained by taking a hypothetical situation. If a company that has been allotted a certain number of credits, taking the incentive that the government is offering, invests in cleaner, low-emission technologies and hence reduces its emissions, it consequently also reduces the number of credits it uses out of those that have been allotted to it. It is hence left with surplus credits. Now if there is a factory that estimates and realises that its emissions will exceed those allowed by the government, and that it does not have enough credits, this trading system allows this factory to buy credits from the company that is not using up its quota. The company selling the credits not only reduces emissions, but also makes money by selling credits. In the present day, there is an active carbon market where credits can be sold or bought and each transaction is looked over by the UNFCCC. There are also some closed markets, like the Chicago Climate Exchange and the European Climate Exchange. These may also have their own validating authority in addition to the UNFCCC.

Two more terms that must be explained here are carbon offsets and generation of carbon credits. In the trading market, there operate a set of middlemen companies that review the emissions of various industries and offer them investment opportunities in projects that reduce carbon emissions. The companies can then reduce global emissions without actually updating its technologies or methodology. This process of second-hand carbon emission reduction is called carbon offsetting, and the middlemen companies are referred to as offset firms. The generation of carbon credits is basically a process that allows countries or companies to obtain more greenhouse gas reduction credits than those they already possess. The Kyoto Protocol provides three such mechanisms: the aforementioned trading of credits, Joint Implementation and Clean Development Mechanisms or CDMs. Under Joint Implementation, a developed country with relatively high cost of setting up carbon emission reduction projects would set up such a project in a developing nation and for its act of reducing carbon emission is granted a certain amount of credits. Under CDMs, a developed country is allowed to ’sponsor’ a greenhouse gas reduction project in a developing country where the cost is usually much lower, but globally, the reduction is the same. The developed country would be given credits for meeting its emission reduction targets, while the developing country would receive the capital investment and clean technology or beneficial change in land use. However, these processes invite many sceptics. Many geologists argue that these programs give a way out to those countries/companies that do not want to compromise on industrial development and are not beneficial overall.

The cap-and-trade system is one of the most sophisticated and comprehensive methods of combating global warming. Despite being an environmental issue, it has integral financial and economic aspects. However, there are various loopholes and drawbacks of this system, making it dangerously inclined towards becoming a problem more than a solution.

Firstly, the system does not stop countries that are not signatories to the Kyoto Protocol from taking part in emissions trading. Countries such as United States of America, China and Australia, that are some of the biggest emitters of the world, do not follow the caps laid down by the Kyoto, yet make billions every year in the carbon market. These countries do not put caps on their industries and still make a lot of money in the emissions trading market. The USA traded almost 23 billion metric tonnes of carbon dioxide in 2007.

Even though this system is aimed at maintaining liquidity of carbon assets, it has only a global level. Since the market is international, it is very hard for regional enterprises to participate, and hence discourages them from investing in cleaner technologies. These regional companies have caps to work under, yet no way of getting the money for the reduction.

Another major problem is that the cost of carbon in the market is lower than the price of low emission technologies. Hence, smaller companies that do not have the capital for these technologies use their money to buy credits. This not only hinders the reduction of emission levels, it also makes them less and less capable of competing with big companies, who not only aim more credits by investing in the required technologies, but also make money on the market. Inevitably, this makes the metaphorical rich richer and the poor poorer. Also, the fact that credits can be passed on from one owner of an establishment to another discourages the relatively newer companies as opposed to old businesses.

In addition, this system does not have a provision for the price of carbon. With lack of homogeneity in prices in different markets, the price of carbon fails to rise, thereby nullifying the incentive. Theoretically, a high price of carbon is vital to this plan. By simple market laws, high prices would indicate to customers which products involve higher carbon emission, and to companies which technologies involve lesser emissions. This was pointed out by Yale economics professor William Nordhaus. Thus, customers would be discouraged from buying high priced commodities. However, this does not happen.

The signatories of the Kyoto Protocol chose carbon credits over carbon taxes, but personally, I believe that the question of whether that was the right choice remains to be answered. Since the caps are set at a lower level than the current emissions and their gradual decrease does in actuality lower emissions, its not that this method is unrealistic or ineffective. The problems its faces, however, paint a different picture. One cannot fail to see how ironic it is that a solution to one of the greatest environmental problems this world has ever faced has become a threat in itself.